What Is Passive Income in Real Estate

Passive income in real estate is income generated from property or real estate investments with limited day-to-day involvement from the investor. Income may come from rent, interest payments, distributions, or other investment returns. An investor does not have to buy a rental property or become a landlord to invest in real estate. They could do that in REITs, real estate debt, crowdfunding, and so forth. Understanding how each approach works can help you determine which fits your financial goals and investment time horizon. 

Key Takeaways

• Passive real estate investing allows investors to gain exposure to real estate without necessarily managing investment properties themselves.
• Real estate can potentially generate income through rent, interest payments, investment distributions, and property appreciation.
• Passive does not mean risk-free. Real estate investments can lose value or income and may expose investors to market, credit, liquidity, property, and interest-rate risks.

Table of Contents

• What Is Passive Income in Real Estate?
• How Does Passive Real Estate Income Work?
• Active vs. Passive Real Estate Investing
• Types of Passive Income in Real Estate
• Potential Benefits of Passive Real Estate Investing
• Risks of Passive Real Estate Investing
• How to Choose a Passive Real Estate Investment
• How Is Passive Real Estate Income Taxed?
• Final Thoughts | FAQs

What Is Passive Income in Real Estate?

Passive income generally refers to income that requires relatively little ongoing work to maintain after the initial investment has been made.

In real estate, the level of involvement can vary considerably. An investor who owns and personally manages several rental properties may spend substantial time finding tenants and maintaining the properties. Another investor might own shares of a publicly traded REIT and have no involvement in managing the property. That means passive real estate investing exists on a spectrum rather than being completely hands-off in every case.

It’s also important to distinguish the everyday use of “passive income” from the IRS definition of passive activity income. For U.S. federal tax purposes, rental activities are generally considered passive activities, subject to important exceptions, while interest and dividends generally fall under portfolio income rather than passive activity income. 

How Does Passive Real Estate Income Work?

Real estate investments can potentially generate returns in several ways. Understanding where those returns come from makes it easier to compare different passive real estate strategies.

Rental Income

A property owner may collect rent from residential or commercial tenants. After accounting for expenses such as property management, routine maintenance, insurance, property taxes, financing costs, and vacancies, the remaining amount may provide cash flow to the owner.

Interest Income

Instead of owning property, investors can gain exposure to real estate through debt. Real estate borrowers often need financing to purchase, refinance, renovate, or develop properties. Investors who provide capital directly or through a real estate debt investment may receive interest payments in exchange for lending that money.

Investment Distributions

REITs, private real estate funds, real estate crowdfunding, and other pooled investment vehicles may make distributions to investors. The source, frequency, amount, and tax treatment of distributions depend on the investment. Distributions are not guaranteed and shouldn't automatically be interpreted as investment profits.

Property Appreciation

Real estate may also increase in value over time. An investor may potentially realize a gain when a property or investment is eventually sold. However, capital appreciation is not the same as recurring income, and property values can decline as well as increase. Investors shouldn't assume appreciation will occur.

Active vs. Passive Real Estate Investing

The primary difference between active and passive real estate investing is how much responsibility the investor has for operating or managing the investment.

Active real estate investing generally requires ongoing involvement. Someone who purchases a rental property and manages it personally may be responsible for tenant issues and making operating decisions. Passive real estate investing shifts much of that responsibility to someone else. A property manager, REIT management team, or lending platform may handle the day-to-day work.

Neither approach is inherently better. Active investing may provide greater control, while passive investing can reduce the investor's time commitment. The tradeoff is that passive investors generally give up some control and may pay management, platform, or fund fees.

Types of Passive Income in Real Estate

The good news is there are many passive income ideas you can use to generate income from real estate investments. 

Rental Properties With Professional Management

Ownership of rental property is one of the direct ways to invest in real estate. Investors buy residential or commercial property and earn income from renting it to the tenants. By hiring a professional property manager, investors could make the ownership of rental property passive. 

Depending on the specifics, property managers could handle marketing, rent collection, and other issues arising from tenants. But managed rental property is not totally hands off since owners still have to monitor the performance of the investment, manage its financing and make decisions regarding the investment. Returns from rental property could be coming from rental income and property appreciation.

Real Estate Investment Trusts (REITs)

A real estate investment trust, or REIT, is a company owning, operating, or financing income-generating properties. These companies could provide investors with real estate exposure without the need to purchase individual properties. The investment portfolio of REIT could consist of residential and commercial properties, offices, multifamily buildings, warehouses, industrial properties, and other types of real estate.

Under the federal tax laws, to be qualified as a REIT, a company must distribute at least 90% of its annual taxable income to the shareholders, among other requirements. Investors should know that there are different kinds of REITs. Publicly traded REITs could be traded on exchange and are liquid. Non-traded REITs could have substantially different liquidity and other features.

Real Estate ETFs

Real estate exchange-traded funds, or ETFs, are baskets of real estate-related securities, which are being offered through a single investment. The majority of real estate ETFs contain many publicly traded REITs and could diversify investor's exposure to the real estate.

Real estate ETFs are traded on the exchanges and thus could be bought or sold during regular trading hours, giving them high liquidity compared to direct real estate ownership and many private real estate investments. But even though ETF is liquid, it does not mean that there is no risk. The price of an ETF fluctuates and could be impacted by the interest rate environment, economy, and stock market fluctuations.

Real Estate Crowdfunding

Real estate crowdfunding allows many investors to pool capital and invest in real estate through an online crowdfunding platform. Depending on the kind of the offering, investors could be buying real estate equity, real estate debt, or a fund, which contains various investments.

Real estate crowdfunding lowers some of the barriers to private real estate investing, but investors should understand what they are actually buying. There is great variability in the investment structures, minimums, fees, holding period, and other factors between crowdfunding platforms and individual offerings. Investors should analyze aspects such as the quality of the underlying property, sponsor or borrower, investment structure, fees, potential downsides and so forth before investing.

Real Estate Notes

A real estate note represents debt secured by real estate. Instead of owning the underlying property, the investor has exposure to a loan associated with the property. Depending on the investment structure, investors may receive interest and principal payments from the borrower.

The important factors of real estate note investments are the ability of the borrower to repay the debt, value of the underlying real estate, loan-to-value ratio, loan term, and procedures of handling default. Real estate notes allow an investor to get income without having to worry about the issues related to ownership of the property, but borrowers could default and an investor could lose money.

Real Estate Funds

Real estate funds are pooled investments using investors' money to invest in real estate assets and securities. Investments could vary depending on the kind of the fund. They could include real estate equity, REITs, publicly traded real estate companies, individual properties, real estate loans, and combinations thereof.

Real estate funds could be publicly traded or privately offered. The liquidity, fees, minimum investment, and other risks of each particular fund can be quite different. Before investing, an investor should know such information as what exactly is the fund holding, how the fund manager is being compensated, when the money could be withdrawn and so forth.

Fractional Real Estate

Fractional real estate investing allows multiple investors to participate in the ownership or economics of a property rather than one investor purchasing the entire property. Depending on the structure, an investor may own an interest in an entity that owns the property rather than holding the property title directly.

Potential returns from fractional real estate investment could include rental income, distributions, and eventual appreciation of the property. However, investors should think of the management fees, operating costs, liquidity, and decision making in regard to the underlying real estate. Fractional ownership could lower the amount of money needed to purchase an interest in the single property, but it is not reducing the risks associated with this kind of investment.

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Private Real Estate Debt

Private real estate debt is financing provided to the real estate borrower outside of the public markets. Usually, the borrower uses the funds to purchase, refinance, renovate or improve a real estate. Loans are often secured by the underlying real estate, and investors may potentially earn income from interest paid by borrowers.

Real estate debt differs from real estate equity because the investor generally does not participate directly in property appreciation. Instead, the investment's performance depends heavily on whether borrowers make their required payments and whether the collateral provides adequate protection if a loan defaults.

These are general characteristics rather than guarantees. Investment structures vary, so investors should review the terms, risks, fees, and liquidity provisions of any specific investment.

Potential Benefits of Passive Real Estate Investing

Passive real estate investing allows investors to get exposed to real estate without the need to manage everything personally. Some of the potential benefits of passive real estate investing are: 

• Passive Income potential. Some real estate investments could be generating income in the form of rental income, interest, and/or distributions.
• Diversification. Exposure to real estate could add diversification to an investor's portfolio compared to stocks and bonds. But diversification does not guarantee against losses.
• Less day-to-day management. Professionally managed investments could reduce time spent on dealing with the tenants, repairs or any other property issues.
• Access to different properties and markets. Pooled real estate investments could provide exposure to different properties than one investor could afford.
• Potential appreciation. Real estate equity investments could potentially profit from increases in the value of the underlying properties, but appreciation is not guaranteed.

Risks of Passive Real Estate Investing

Passive real estate investing is not risk-free. All real estate investments could lose money, and different ways of investing could have different types of risk.

• Market Risk: Real estate values could decrease due to economic downturn, changes in supply-demand balance, population trends, local conditions, and other reasons.
• Income and Vacancy Risk: Renting properties could face vacancies, rent defaults, decreased rents or unanticipated expenses impacting cash flow.
• Credit and Default Risk: Real estate debt investments depend on borrowers making required payments. A borrower default can reduce or eliminate expected income and may result in a loss of principal.
• Liquidity Risk: Directly owned properties and many private real estate investments cannot be sold quickly. Investors may have to hold an investment for years or may only be able to exit under certain conditions.
• Leverage Risk: Borrowing can magnify investment returns when an investment performs well, but it can also magnify losses when property values or income decline.

Final Thoughts on Passive Income From Real Estate

Passive real estate investing could provide an investor with exposure to real estate without requiring them to handle all management aspects. The ways to do so could vary from publicly traded REITs and ETFs to directly owned rental properties and various private real estate equity and debt investments. All these ways have their own potential sources of income, appreciation, liquidity, fees, control, and risks.

The right approach depends on your financial goals, risk tolerance, time horizon, available capital, and due diligence. Before investing, understand how the investment generates returns, what fees you'll pay, when you can access your money, and what could cause you to lose money. Interested in learning more about real estate investing? Explore the Concreit blog for more educational resources about real estate and income investing.

Frequently Asked Questions

How much money do you need to generate passive income from real estate?

There is no specific minimum amount of capital required for investing in real estate. Directly purchasing a real estate investment usually requires significant upfront capital. But publicly traded REITs and real estate ETFs could be purchased in small amounts through brokers.

Is rental property really passive income?

Rental property could be earning passive income for tax purposes in many cases. But owning a rental property is not necessarily a passive investment for time management. By hiring property management companies, investors could make the investment passive, outsourcing all rental responsibilities. For the U.S. federal tax purposes, rental activities are considered passive activity, but there are important exceptions.

How is passive real estate income taxed?

The tax treatment of real estate investment income depends on the type of investment, how it is structured, and the nature of the income received. Because tax treatment depends heavily on individual circumstances and investment structure, investors should consult a qualified tax professional rather than assuming all passive real estate income is taxed the same way.

How much passive income can you make from real estate?

There is no fixed return from the real estate investments. The return depends on the particular type of investment, amount invested, performance of the property/loan, market conditions, etc. But the higher the expected return, the higher the risk.

Can you earn passive income from real estate without owning property?

Yes, investors could get exposure to the real estate without the direct ownership of the property through investments such as REITs, real estate ETFs, real estate funds, crowdfunding investments, and real estate debt.

What is the easiest way to invest passively in real estate?

It depends on the investment. Publicly-traded REITs and real estate exchange-traded funds usually require minimal effort on the part of the investor in terms of their management, whereas rental properties usually involve a greater degree of effort even when property managers are utilized.

What is the difference between real estate debt and equity?

Real estate equity is an ownership interest in the real estate or in the company owning real estate. The owner of real estate equity may profit from its income and appreciation, but he also bears the risks associated with declining values of property. Real estate debt is the money loaned to a borrower and earning interest income for the lender.